Are credit spreads about to widen dramatically in the United States in a way that could generate large losses for the holders of high-yield bonds?
The yield premium on high-yield bonds versus U.S. Treasuries of similar maturity is just about as narrow as it has ever been in history at only 2.8%.
When credit spreads widen, they can have large losses for unhedged corporate bond investors. For example, during the global financial crisis, the Bloomberg U.S. Corporate High Yield Bond Index had a total return of negative 35%.
Delinquency Rates on the Rise
Currently, there are plenty of warning signs that credit spreads may soon begin to widen. For example, delinquency rates on credit card loans have soared to their highest levels since 2011. Credit card delinquency rates were also soaring before the global financial crisis – well in advance of that widening of credit spreads that left corporate bond investors with large losses.
Likewise, auto loan delinquency rates have risen to their highest levels since 2010. However, not every kind of loan delinquency is at alarming levels: mortgage and business loan default rates remain relatively low, although both have also been rising.
Fed Policy Uncertainty
Looking ahead, investors may want to ask if the Federal Reserve’s monetary policy is also likely to contribute to a widening of credit spreads. While the Fed has recently eased policy by 100 basis points, rates are still 425 basis points higher than they were three years ago.
Additionally, a rapidly changing public policy environment may create uncertainties regarding corporate cash flows. In this environment, investors with exposures to these markets may want to look at ways to hedge portfolio risk and futures on credit products offer an exchange-traded, centrally cleared way to limit those exposures.
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